Description

EXECUTIVE SUMMARY

Aircastle seems to be a proverbial baby that has been thrown out with the credit crisis bathwater. The stock has been cut in half from its July peak, trades around 10x PE and boasts a 12.6% dividend yield. Since its IPO, AYR’s earnings and dividend have doubled, yet it trades below the IPO price from 1 ½ years ago. A dividend yield of the magnitude of Aircastles’ suggests a stock whose earnings and dividend paying ability are in danger of significant impairment. In fact, the stock has sold off in lockstep with other financial companies that accurately fit that description. Paradoxically, Aircastle’s business fundamentals remain very strong and the dividend was just raised in December.

Aircastle’s sell-off since the summer is based on uncertainty regarding its funding capacity. Aircraft leasing is a new business for the public markets and I believe that the market is misunderstanding the risk associated with its financing requirements. Even if the capital markets were closed to Aircastle for the next two years, it is highly unlikely they would see any diminution in earnings as their current portfolio of aircraft are on lease and are thus generating stable revenue to fund the dividend. Planes coming off lease are being snapped up quickly by Airlines desperate to get their hands on aircraft in a very tight market. Were Aircastle unable to access the capital markets, the profitability of its incremental growth would be impacted, but its current earnings stream would not. However, Aircastle is priced as if it will never grow again and as if its earnings and dividend are in danger of being cut in the near term.  Not only do current earnings appear secure, but the bank loan market, in point of fact, remains open to Aircastle (See recent Financial Times Article below). Essentially, the holder of Aircastle is being paid a 12.6% dividend yield to wait until the securitization market reopens. Once the credit fears abate, Aircastle should trade at a normalized valuation of a 6% dividend yield which would imply a return would be over 100%.

http://www.ft.com/cms/s/436355b6-e345-11dc-803f-0000779fd2ac.html

DESCRIPTION

Aircastle (AYR) is an aircraft leasing company that was formed by Fortress in late 2004. It has a $5.7bln aircraft portfolio (including commitments) which consists of 157 aircraft leased to 57 lessees in 32 countries. Fortress took AYR public in August 2006 at $23 per share. Since the IPO, AYR has increased its dividend five times and now stands at $2.80 per share or a 12.6% yield. Aircastle’s lessee’s are geographically diversified with only 12% of its lessees located in the US. This is important because I believe there is a misconception that Aircastle is a US focused company with exposure to the domestic air travel market and a US recession. Aircastle is also diversified by segment with almost 30% of aircraft used as freighters, which benefit from longer lease terms, longer lives, and fewer capex requirements as they are more fungible between lessees (no need to format cabin to match the rest of the fleet). Aircastle is also diversified by lease expiration date as well. Importantly, 85% of its aircraft are latest generation technology for their class which ensures their fuel efficient aircraft will stay in demand.

The company is structured like a REIT paying out almost of all its economic earnings to equity holders and 70-75% of available cash flow after debt payments. Management described their dividend strategy on the most recent conference call: “our approach on the dividend has been pretty consistent since the beginning. We try to take a best view of the run rate earnings power, the real economic earnings power of the Company, and pay that out as a dividend. Nothing has changed. During the fourth quarter when our Board of Directors got together, we took a look at the market as it existed there, looked at the revenue picture, which I think is in pretty good shape; looked at where we would project the financial markets to be and came to the conclusion that we should pay the dividend we paid. It's a quarter by quarter thing, but our philosophy is the same and we are not holding anything back. It's what we think is a real economic power of the Company.” In order to finance the purchases of new aircraft and grow the business, AYR relies on credit lines, debt securitizations and equity financing. Aircastle’s most recent equity offering was in October 2007 at $31.75 per share.

MANAGEMENT

Management, led by CEO Ron Wainshall, is one of the strengths of this company in my opinion. Ron previously ran the asset management group at General Electric Commercial Aviation Service (GECAS) meaning he is extremely familiar not only with the aircraft market, but also various lessees in the market. He is a graduate of Wharton and received an MBA from Chicago Business School. He owns over 300,000 shares of AYR worth approx $6m. As Aircastle must re-lease the same aircraft several times during its useful life, the relationships he and other members of the management team have developed over their careers are essential to placing existing aircraft and also finding the best deals for new acquisitions. Management’s experience allows them buy airplanes wholesale versus competitors who must use sourcing agents. 

The management team has proven to be very conservative and methodical. An example is their focus on the freighter market which makes up 30% of their portfolio. They seem alone in focusing in on the freighter market and have mentioned that they do not see anyone else taking commercial aircraft and converting them to freighters. They recognize a situation where the lease rates are equivalent to commercial rates, but the lease terms are longer, the useful life of the asset is extended and most importantly the cost for them to change lessees is minimized. By focusing on freighters with 35 year useful lives as opposed to 25 year useful lives of commercial jets, AYR can purchase older aircraft at lower prices, but lease them at rates equivalent to commercial. This improves the yield of their investments. In addition, the freight market is also a hedge against the commercial market as it is less susceptible to event risk.

Management is also very risk averse. On a conference call in March 2007 in response to a question about whether or not they would prefer to lock in current rates as far out as possible or use shorter lease terms to capitalize on potentially higher lease rates in the future, management responded by saying: “our general risk position is to take as little risk as possible, which means that we would lock in lease rates if we thought they were reasonable and we would push out terms to the extent it's available.”  On the most recent conference call this month, management’s comments regarding their belief that they would do very few deals in the first half of 2008 precipitated a large drop in the stock price. What they said, however, would make any value investor smile. They said that they did not think they would be active in the deal market in the near term because prices were too high. Wainshall stated “looking ahead, we will continue to apply the same discipline and investment approach we always have and will only seek to make incremental investments if they are accretive. At the moment, we are not finding many opportunities which we consider to be attractive. As a consequence, we believe our incremental investment activity will be limited during the early part of 2008.”

LEASING MARKET FOR AIRCRAFT

Supply of new aircraft is a virtual drip as Boeing and Airbus, the two main suppliers of commercial aircraft, have backlogs ranging from 4 to 6 years. Concurrently, older, less fuel efficient planes are being taken out of service by major operators as the rising cost of fuel makes them uneconomical. This means that the supply of aircraft is fixed at best and is most likely declining. This supply shortage is especially acute for “modern” fuel efficient aircraft in which Aircastle has invested the bulk of their portfolio.

Not only is supply extremely tight, but demand for aircraft is strong and growing. Global demand for aircraft is being driven by the growth in China, India and other emerging economies where a burgeoning middle class whose population and wealth are increasing is eschewing traditionally cheaper means of travel and increasing their demand for air travel. One needs only to look at the combined increase in gross orders in 2007 for Airbus and Boeing and see that it was up 53% y/y and 66% YTD in January 2008 to see how strong the underlying demand is. In addition, manufacturers are pushing out delivery commitments as they are unable to live up to their original time frames. The CEO echoed these statements saying in the February 2008 conference call saying “despite the financial market volatility and the present United States slowdown, we continue to see robust lease demand for modern aircraft models around the world. In general we see rental rates for most aircraft types being at least as high as they were last year. In some cases, like for the mid body A330 and the Boeing 767 models, which are in short supply due to relative market growth and new product limitations and delays, the rental increases are pronounced and are at least as much as 10% and even 20% compared to last year. We believe several factors are contributing to the market's continuing strength, including, first, the large and growing new order backlogs at Boeing and Airbus; secondly, the weakness of the U.S. dollar and resulting cheapness of dollar market assets, such as aircraft; thirdly, worldwide travel demand is continuing to grow rapidly and broadly while high fuel costs are exerting continuing pressure on operators to retire less efficient and older technology aircraft.”

The supply/demand fundamentals are incredibly favorable for aircraft leasing companies. The current tightness in the aircraft market is allowing Aircastle to lease planes at higher rates (5-10%) and for longer terms (~7yrs). The main risk to Aircastle’s earnings stream and their dividend is whether or not they can profitably re-lease aircraft when they come off their leases. In the current environment there is very little risk here. They have already leased their entire 2008 vintage and are well on their way to placing the 2009s (40% completed). Management is quite confident they will place the rest of the 2009s as they generally do not place leases further out than one year. Management stated in the November 2007 conference call that “having commitments or even serious placement discussions for use of aircraft that far ahead of lease expiration (2009) is really unusual and reflects the tight supply of aircraft in the market right now. Our take on it is that airlines are very concerned about losing their capacity, and they're doing what they can to secure key assets.”  I would argue that based on the backlogs at Boeing and Airbus, the tightness in the leasing market will persist for the next several years. This is a tremendous tailwind at the back of Aircastle. This is a key point and I think where the market is tremendously confused. If the aircraft are leased then the revenue is certain barring a default and in which case they would be able to repossess the aircraft within 60 days and then likely re-lease it. In addition, Aircastle management has said they have no current credit issues as all of their lessees are current and performing. Aircastle’s ability to access the capital markets impacts its growth, but not its current earnings.  

BUT THEY HAVE TO GROW, DON’T THEY?

This is not a company for the Buffett schism of the church of value investing. Unlike, land or real estate, aircraft are depreciating assets which means leasing companies must continually replace their assets over time. Over the long term, as aircraft age they are unable to demand the same lease rates they once were and the earnings power of the portfolio will decrease. When this occurs, new aircraft must be acquired to make up the shortfall in order to maintain stable earnings power. I would argue that this impact will not be seen for many years as evidenced by renewal lease rates that are currently RISING for jets that are ~5 years older then when they were previously leased. This is being driven by the tightness in the leasing market which in turn is being driven by the huge backlogs at the manufacturers and the growing global demand for aircraft. As long as these situations persist, the diminution of Aircastle earnings power from its current fleet over time will be minimal. It is most likely that the credit markets will re-open long before the global the aircraft supply and demand imbalance corrects.

 In order to remain profitable, aircraft leasing companies must  be run by savvy managers who are able to purchase aircraft at cheap enough prices that allow them to them lease them profitably. There is no moat and prior to the credit crisis, financiers were lining up to get into this business. Economics 101 would suggest that as time progresses and more players enter the business, the spreads will erode and profitability will decline. However, in the near term I have confidence that Aircastle’s model will remain strong as we have good visibility in earnings for the next few years. Paradoxically, the credit crisis has provided a temporary moat for Aircastle as its potential competitors have been unable to enter the business due to the closure of the IPO and securitization markets.

The deputy chairmen of Aircastle made the following comments in the August 2007 conference call that exemplifies the situation they are now in: “We are very comfortable where we are today. And I think we're very comfortable with our positions, our liquidity, our funding, and our capital position. Obviously, if things got worse, you would potentially slow down the rate of acquisitions until you had matched up your funding. So we have the ability to do that. If we stop acquiring, we have tremendous cash flow generation. Because as you remember, part of our rent is really return of principal. So if you collect 14% on your portfolio on average, we have tremendous cash-generating capability if we were to stop acquiring assets. And so we're not concerned about it. We're obviously -- to the extent that cost of capital increases for everybody, which is a possibility, you would expect to see asset prices probably come down a little bit. So we are in the business of investing at a margin. And so it's possible that as we go forward, there will be some opportunities that may come up that would not have otherwise been available.”

It should be noted that AYR expects to close a financing term facility in the next few months. They expect the all-in (including interest rates hedges) cost to be 7%. This compares to previous securitization all-in cost of 6.2%. Clearly financing costs have risen and the margins on new acquisitions may be affected. However, this should be somewhat offset by higher lease rates. In no way does this potential slight decrease in margins on incremental business justify a 12.6% dividend yield and a halving of the stock price.

VALUATION

Clearly a 12.6% dividend yield itself is indicative of a very inexpensive stock. In addition, AYR now trades around 10x ’08 earnings which is about one half of where it has traditionally traded during its short history.  Aircastle’s low valuation implies virtually no growth assumptions. While there may be no growth in the near term, given the strength of the aerospace market and Aircastle’s management, it would be irrational to assume they will never grow again. Therefore the resumption of growth, when it does occur should, act as a catalyst for multiple expansion.

Aircastle trades roughly in-line with its airline leasing peers and other leasing companies based on P/E multiple, but its dividend yield is roughly double the overall peer group average. As Aircastle has indicated many times that their financials are backward looking, but their dividend is forward looking, I feel as it is more appropriate to make a relative valuation call on this company based on their dividend yield rather then its P/E. I believe P/E multiple is an indication of its absolute cheapness and diminished growth expectations.

Several indicators point toward a 6% dividend yield as fair value for Aircastle in addition to the peer group average. All three of Aircastle’s equity offerings including its IPO were priced based on a roughly 6% dividend yield. The most recent of these occurred in October 2007. Currently, the REIT index averages 6.2% dividend yield as well. Given the declining asset values and capital issues many of those real estate companies are facing, it seems absurd that Aircastle, whose assets are actually appreciating and remains able to access the capital markets should trade at roughly double the yield of these REITs.  

Finally, I believe that there is a good deal of margin of safety in Aircastle beyond the contract based cash flows, strong management and high dividend yield. The CEO made a comment at the Goldman Sachs Finance conference earlier this month that gives me further confidence that there is a large margin of safety based on the asset value inherent in the company. He said “there isn’t anything fundamentally wrong with the company and it is close to trading at NAV as if it is just a repository of airlines.” Aircastle trades at 1.3x book value. However, it is very possible that book value understates the value of its portfolio as Aircastle has been decreasing the carrying value of its fleet based on straight-line depreciation whereas the actual values of the aircraft have been increasing as evidenced by the rising rents. Aercap made a similar claim today during their earnings presentation showing a slide depicting the appraised value of their portfolio to be significantly higher then the carrying value.

SUMMARY

Aircastle is an interesting play on the global growth of air-travel without risk associated with of individual carriers. The aerospace industry has massive tailwinds and Aircastle is positioned to strongly benefit. Management has indicated that they believe the dividend to be secure and have expressed their confidence by raising it as recently as December. Two insiders bought stock (2,000 shares each) on 2/26/08 further signaling confidence in the story. This stands in stark contrast to the market which has halved the stock on fears that its growth will be less profitable or slowed.  Management has stated that while its financials are backward looking, its dividend is forward looking and reflects their view of future earnings. Given the prodigious yield, it appears that Aircastle shares are a great bargain available because it has been mistakenly tainted by the credit crisis.

Catalyst